Investment opportunities within European small caps

By FUNDSUPERMAT RESEARCH TEAM / Pic By BLOOMBERG

Transatlantic trade tensions have retreated from the limelight after the trade agreement back in July between the US and Europe.

General details on the deal include cutting tariffs on non-auto industrial goods to zero and to increase US exports to Europe.

While some market observers may heave a sigh of relief, significant trade risks still lie on the horizon given the trade agreement is not binding and trade negotiations may see further complications.

If the Trump administration’s record of upending relationships at a whim is any indicator of the future, we should not be ready to celebrate just yet.

It is perhaps an opportune time to consider the potential economic ramifications of the “America First” trade rhetoric.

From a trade perspective, Europe stands at a relatively precarious position. Even though the economic make-up of the various individual economies within the eurozone differs in terms of domestic market resilience, the region is generally highly reliant on exports to the US and emerging markets relative to other developed economies to drive corporate earnings.

Global brands such as Volkswagen, Unilever, LVMH, Mercedes-Benz and Airbus have substantially grown their non-European earnings exposure over the past few decades.

European-based small-cap companies, however, tell a different story. Their revenue sources are more domestic driven and therefore are more shielded from any escalation in trade tensions.

Using the entire Bloomberg universe of European-listed companies that report geographic revenues, we found a significant proportion of large-cap firms (defined as companies with more than US$10 billion [RM41 billion] in market capitalisation) generate more than half of their revenues outside of Europe.

Despite so, it should be noted there are significant dispersions in terms of non-European earnings exposure, varying from country to country.

For instance, companies domiciled on stock exchanges of Switzerland, the UK, Netherlands, Germany and France tend to be larger and have more globalised operations compared to those from the Nordic or Turkish stock exchanges — hence the dispersion in domestic earnings generated.

If we use the S&P 500 as a gauge of how the revenue exposure of the broader US economy is like, the index’s ~67% exposure to domestic revenue points to a highly insular and consumer-driven economy.

It is this aspect about the US, which allows the current US administration to be forceful on trade issues with its partners.

Both the US and European Union stand to lose out from enacting reciprocal trade barriers, however, Europe looks poised to be the biggest loser.

Investors seeking exposure to European equities with low risk to trade tensions may want to consider investing in the smaller cap space.

Two reasons may attribute to why both the small-and large- cap European equities are now trading above their fair price-to-earnings (PE) levels.

Firstly, investors today are incentivised to take on more risk to generate a high rate of return given the negative interest rate backdrop.

European equities have seen earnings upgrades, which have provided a boost to market sentiment and expectations of future earnings, consequently pushing prices higher.

As of end September 2018, valuations of European small caps as measured by the 12-month forward PE of the MSCI Europe Small Cap Index stands at 17.9 times, considerably higher than the broader MSCI Europe Index of 14.7 times.

At current prices, we do not think valuations of European small caps are excessive, considering smaller companies often command a higher PE ratio over their larger-cap peers due to their higher growth potential.

These companies can also offer investors some reprieve from any potential negative shift in exports and trade
sentiment.